Why Do Investors Fear ARMOUR Residential More than Annaly?

ARMOUR Residential's large discount to book value is driven by a variety of factors that explain why the market has comparatively more confidence in Annaly Capital Management.

Jul 14, 2014 at 5:59PM

Source: Company

Investors in mortgage REITs learned a valuable lesson in 2013: Do not only focus on the dividend yield when you need to decide about your income investments.

And investors in ARMOUR Residential REIT (NYSE:ARR) certainly learned that lessen the hard way as its book value per share and its share price fell off a cliff in 2013 in light of a more restrictive monetary policy of the Federal Reserve.

Mortgage REITs have been extremely attractive investments over the last five years when low interest rates and a collapse in the housing market fueled speculation in residential mortgage-backed securities.

Mortgage REITs take on pretty large amounts of debt and invest their short-term funds in long-term mortgage securities. This is a risky business model, which has worked well from 2008-2012, but it relies on favorable market conditions for leveraged investment strategies, namely low debt costs and the availability of leverage.

Mortgage REITs disappointed investors in 2013
Investors made a crucial mistake as 2013 come around: They solely bought mortgage REITs such as Armour Residential or Annaly Capital Management (NYSE:NLY) because they chased their double-digit dividend yields, but didn't factor in underlying book value declines as a result of increasing long-term interest rates.


Source: Company

Mortgage-backed securities are immensely complicated investment structures, but rising interest rates (implying higher interest rate volatility) will reduce the value of investment portfolios that are largely invested in mortgage-backed securities.

Though ARMOUR Residential's dividend yield, which has stayed at the upper end of the yield spectrum at 14% for a long time, was appealing to investors, the total return really does not look that great.

Even though investors may have benefited from a 14% dividend yield, this seems like a rather poor return considering that ARMOUR Residential's shares actually lost 38% in 2013.

Shares of Annaly Capital Management lost 29% of value, but the market seems generally more optimistic about the industry leader than ARMOUR Residential.

Book value discounts
As can be seen in the chart below, Annaly Capital Management consistently traded at lower discounts to book value compared to ARMOUR Residential over the last year.

Presently, ARMOUR Residential trades at a 17% discount to its first quarter 2014 book value per share of $5.23 whereas Annaly Capital Management trades at a 9% discount to its Q1 2014 book value per share of $12.30.


And the reasons for the apparently more negative attitude of investors with respect to ARMOUR Residential are quickly identified: High leverage ratios, ongoing book value declines and a less reliable dividend record all contribute to ARMOUR Residential's comparatively large discount to book value.

1. Leverage
ARMOUR Residential has generally had high leverage ratios in the past. At the end of the first quarter of 2013, ARMOUR Residential reported a leverage ratio of approximately 9:1. Fast forward one year and ARMOUR Residential has brought down its leverage ratio a bit to around 8:1.

Though investors have seen a slight decrease in indebtedness, leverage ratios are still relatively high particularly considering that many mortgage REITs have largely de-risked their balance sheets in 2013.

Annaly Capital Management, for instance, reported a leverage ratio of 5.2:1 in the most recent quarter and a ratio of 6.6:1 in the first quarter of last year. In other words: Compared to ARMOUR Residential, Annaly Capital Management is significantly lower leveraged and also de-risked faster than ARMOUR Residential.

2. Doubts about the stability of ARMOUR Residential's book value
The second reason for the valuation discrepancy between these two mortgage REITs relates to their different book value developments. While Annaly Capital Management reported a slight sequential increase in its book value in the first quarter of 2014 to $12.30 per share, ARMOUR Residential reported another sequential decline in its book value per share from $5.32 to $5.23 in the most recent quarter.

Investors are highly skeptical of mortgage REITs, that have not yet stopped the bleeding of book value. Declining book values may foreshadow dividend cuts and investors don't hate anymore than cuts in their distributions.

The market still has doubts about ARMOUR Residential's book value stability. A return to sequential book value growth, however, could be a catalyst for ARMOUR Residential's stock.


3. Dividend record
Last but not least, dividend records play a large role in the different perception of the two mortgage REITs. Annaly Capital Management pays investors regularly since 1997 and is a industry-leader that carries some weight in the marketplace. Put differently: Its dividend record has much higher credibility than the one of ARMOUR Residential which pays investors only since 2010.

A reliable dividend record over a variety of business cycles carries a lot of value when investors question underlying book values and the future profitability of the companies involved in the sector.

Looking ahead
Higher leverage ratios, ongoing book value declines and a shorter, less reliable dividend record are the reasons why investors correctly perceive ARMOUR Residential as riskier than its larger mortgage REIT rival Annaly Capital Management.

Both mortgage REITs still suffer from a loss of investor confidence due to a series of dividend cuts and book value declines in 2013. Annaly Capital Management, however, gets the benefit of the doubt whereas ARMOUR Residential will have no other choice but to prove itself in 2014.

Boost your investment income today
Our top analysts put together a report on a group of high-yielding stocks that should be in any income investor’s portfolio. To see our free report on these stocks, just click here now.

Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information

Compare Brokers